Cyprus: Real-time assessment

The agreement finally signed between the Cypriot government and the Troïka in the first hours of March 25th is apparently a better solution than what was decided previously. This first agreement signed on March 16th, it has to be recalled, was rejected by the Parliament of Cyprus after creating a major political comotion. The first, and most important difference, is of course that deposits of less than 100,000 euros will not be affected. But this agreement only serves to confirm what we already knew: it is in keeping with the stranglehold exerted by Germany over the entire salvaging process. Especially, it establishes a dangerous precedent. Beyond this, the implementation of this agreement will meet with numerous difficulties. Given the flight of capital which occurred between March 16th and 25th, the accounts above 100,000 euros will have to be taxed over 70% (and not 30%, as had been initially announced). This agreement is loaded with threads for the whole of the Eurozone, but especially for Cyprus, which it condemns de facto to a considerable impoverishment.

The Pyrrhic victory of Germany

This agreement signs the triumph of the German strategy. Germany finds itself in the following contradiction: she wants to preserve the existence of the Eurozone, from which she draws maximal profit, but she wants to preserve it at the least cost possible to herself. Whence the idea, in the case of a banking restructuration, to put to contribution not only the shareholders (as would be normal) but also all or part of the depositors. This is why Germany showed herself unbending during negotiations. She thus obtained that a large part of the contribution to the necessary amounts (5.8 billion out of 17.5 billion) originate from the “shearing” of the depositors. She can therefore continue with her politicy, according to which a crisis must be paid for above all by the country which endures it. One may point out that this policy is very close, in its principle, to the one put in place by the United Kingdom towards Ireland at the time of the famine of 1847. There, too, it was asserted that assistance had to be paid for by the Irish for the most part. We know what came of that. [1] It is unheard off, incidentally, that a French minister, Pierre Moscovici (not to call his name…), should have given his approval to this strategy. But this strategy could prove itself counterproductive in the relatively short-term. Indeed, the more than clumsy declaration of the president of the Eurogroup stating that what was done in Cyprus would serve as a model to treat other crises, provoked on Monday, March 25th, an understandable fright on the financial markets.

Even if this declaration was later denied, even if numerous authorities, such as François Hollande, have insisted on the “peculiar” character of the Cypriot situation and the “exceptional” nature of the measures taken, the damage is done. From now on, at every new crisis, the fear of being treated like the Cypriots will take hold of the people, and this will render ever more difficult the search for a solution. By clamping down with a heavy iron hand, the Germans have durably compromised whatever trust was left into the banking systems of the Eurozone. In order to prevent a massive flight of capital, Cyprus will have to establish capital controls, which in theory are proscribed within the Eurozone. The latter finds itself in the situation of having to accept the very principle of measures which it always rejected, because they belied in fact the advantages of the single currency. This is not the least of the paradoxes of this crisis.

Two Euros ?

The implementation of strict capital control sis de facto introducing major a segmentation in the Eurozone. We are to see in the forthcoming days a « Cyprus » Euro and another Euro for the rest of the European Monetary Union. Transforming the « Cyprus » Euro into the second one is to be submitted to very strict regulations. The fungibility of the « Cyprus » Euro is to be far more restricted than the other, and quickly we will see appearing a discount rate between both Euros which is to be no less than an exchange rate in disguise. As said Raoul Ruparel, chief economist at Open Europe, a London-based research group: “Now there are two euros, one in Cyprus, one elsewhere (…). The whole point about a single currency is that money is fungible, it can cross borders without any restrictions. The capital controls in one member basically ends that arrangement.”

Never have we seen the Eurozone going so far toward a complete explosion. One can argue that capital controls were to be needed in Cyprus. This is certainly right. But if for the sake of keeping a country into the EMU one have to take actions which amount to violation of the very principle of the EMU, what is the point of taking these actions ? As a matter of fact Nobel Prize Paul Krugman has made clear that it could be the well thought interest of Cyprus to walk out the EMU[2]. Another Nobel Prize winner (2010), Christopher Pissarides, was appalled by Europe’s plan to impose a tax on deposits in Cypriot banks. He wrote in an interview for Bloomberg Businessweek “Small countries be warned when joining the euro zone. You could be bullied any time by your big brothers if it suits their political objectives.”[3]. Pissarides was even more more specific by last Monday, March 25th, where he said:” “we should sit down and think very carefully about the future of this country and whether it’s better to be within the euro zone or without. We’ve seen that if you run into trouble you’re not necessarily going to be rescued in a way that’s most beneficial to your economy,[4]”

The weaknesses of the plan of March 25th

Moreover, in the case of Cyprus, success risks not to be forthcoming. The Central Bank of Cyprus maintains the closing of the banks until Thursday. Then we shall see if a “bankrun” takes place. The traumatized population has no reason to trust in the banking system. Beyond, this, the question of the technical success of this plan remains in the offing. We now know that a non negligible part of the money deposited on the Cyprus Popular Bank and on the Bank of Cyprus has exited between March 16th and 25th. These movements occurred either through the subsidiaries of these banks (which contrarily to the parent companies had not been closed), either by the way of exception clauses which the ECB, having organized the monetary blockade of Cyprus, had been compelled to establish rapidly. The amounts which have evaporated are of 4 billions minimum and might be as high as 10 billion euros. Monetary authorities will have no choice. If they want to get together the necessary amounts (5.8 billion euros) foreseen in the plan, they will have to increase the tax on deposits over 100,000 euros. From a tax of 30%, one might have to go to a tax of 80%. This would be tantamount to a confiscation of deposits, and would provoke the flight of deposits of less than 100,000 euros, not only away from the Bank of Cyprus, but from other Cypriot banks as well. The plan, which was supposed to avoid a total collapse of the banking sector, would in fact bring it about. We shall see very soon, beginning Thursday March 28th, in fact, what is in \pard softlinestore. But it is not to be excluded that this plan might prove in the end to be insufficient and that new negotiations will be engaged as early as next week for an additional plan. In which case, we would be back to square one. It should be noted that Russian companies, the liquidities of which would be taken hostage in the process of the heavy taxation of accounts over 100,000 euros, could attack the Cyprus government according to international law, introducing numerous legislative procedures with iffy outcomes.

The coming crisis

Finally, this crisis is an important signal as to the rampant crisis the Eurozone is going through. The simple fact that a country representing only 0.2% of the GDP of this zone can create such a problem is certainly a symptom of a much degraded situation. President François Hollande will bite his fingers for having asserted, with rare aplomb und rare recklessness, that “the euro crisis is behind us.” In fact, it’s all the contrary. Already, Slovenia, which is going through a considerable crisis of its banking system, is about to knock at the door. While the economic situation is continuing to degrade itself in Spain, where unemployment is about to climb over 27% of the active population, and public debt is about to reach 100% of GDP, and while Italy is set to go through a grave crisis in the coming weeks, in relation with the impact of the contraction of credit on small and middle-sized businesses, time is no longer to bluster. Now, the method employed in Cyprus contains all the ingredients necessary to provoke a panic among Spanish and Italian depositors. A contagion process extending to these two countries would signify the explosion in the short term of the Eurozone. The best solution remains, while there is still time, to proceed in a coordinated manner to the disolving of the single currency in order to preserve coordinating mechanisms between repossessed national currencies, for instance, within the framework of a common currency system. To some extent implementation of capital controls could be an involuntary step in this direction.

This blog aims at the dissemination of some of my research works, including working papers, position papers or brief notes focusing either on the Russian economy (from macroeconomy to regional economics and finance) or on the European one, with a special attention to the Eurozone crisis.